Citi agrees to do cramdowns

After meetings with lawmakers, Citigroup has agreed to back legislation that would allow bankruptcy judges to alter the amount due on mortgage principal, so called cram downs.

As it stands today, all other debtors including corporations have the cram down option available in bankruptcy court. However, changes to bankruptcy law have eliminated this option for mortgages, creating an impasse as house prices have dropped.

This is how Reuters describes the Citi agreement:

Financial giant Citigroup Inc has agreed to support a controversial rewrite of U.S. bankruptcy law aimed at helping troubled mortgage borrowers, three Democratic senators said on Thursday.

Senators Richard Durbin of Illinois, Charles Schumer of New York and Christopher Dodd of Connecticut said the legal reform would help “millions of families save their homes.”

Citigroup has agreed to support, under certain conditions, a rewrite of bankruptcy law. Under the change, known as “cramdown,” bankruptcy courts could alter the terms of mortgages, subject to certain conditions, the senators said.

Citigroup had no immediate comment.

Only mortgages entered into prior to the date of enactment of the bill would be eligible for the treatment, they said.

Homeowners would have to certify that they have tried to contact their lender before filing for bankruptcy, they said.

Only major violations of the “Truth in Lending Act” would invalidate creditor claims on bankruptcy, they said.

I am all in favour of cram downs. They represent an effective and speedy way to move house prices down to a stable equilibrium level. And I would much rather recapitalize a bank doing cram downs, to the degree cram downs cause distress in the financial sector, than just handing free money to the financial services sector.

Tanta of Calculated Risk was also in favour of cram downs and indicated so in several posts there. CR recently mentioned the issue and has several links to her posts in their recent post. See the link below for links to her insightful commentary.

Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty five years of business experience. He has also been a regular economic and financial commentator in print and on television for the past decade. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College.

Not sure I'm as positive on 'cram downs'. For starters, reducing the principal owed by borrowers to the banks will reduce the banks' assets (already sharply written down).

But secondly, and more significantly, the incentives this creates are simply awful. It effectively punishes those borrowers who have been prudent and not overstretched themselves, and rewards those who overextended themselves.

You may think this isn't the time to worry about moral hazard, but you'd be wrong – it is precisely in the actions we take (and show we are willing to take) in crises that will have repercussions for years to come that matter when it comes to moral hazard. (See Willem Buiter's excellent post on the matter: https://blogs.ft.com/maverecon/2008/11/never-mind-…

Kardy, I hear where you are coming from Barry Ritholtz over at the Big Picture takes a negative view of cram downs.

I would say, though, that they are only used in bankruptcy. So when you talk about moral hazard, you are really talking about people who already face bankruptcy. I think the moral hazard is greatly diminished already as a result. Remember, these are people who have their credit eviscerated for the next seven years. I see this as a quid pro quo: if you are willing to declare bankruptcy, we are willing to allow a third party (a bankruptcy judge) change the loan principle.

The alternative, which I don't see working is to let the bank modify the loan. The problem there is that you DO have moral hazard. The homeowner gets a freebie (except to the degree she owes taxes on the loan forgiveness, which is often the case), while the bank is forced to write down the loan and takes the hit anyway. This is why banks aren't doing loan modifications in greater numbers. Moreover, modifications for some but not for others is another moral hazard favoring home owners with weaker financial profiles. If we do mods, they should be forced o modify EVERY SINGLE LOAN of the same time period to be equitable.

So, I would say the present state of affairs increases moral hazard while cram downs would reduce them. Either way, the government should make any bank recapitalisations dependent on loan modification or cram-downs. That is to say, part of the TARP should be the government guaranteeing to top up a solvent bank's capital base back to where it was before the bank conducted mass cram-downs/modifications. This would incentivize banks to do modifications and cramdowns.

Certainly, that would technically be a bailout. So, you get a new moral hazard. However, there are no really good solutions here. The debt loads are too large for both homeowners and banks.